[Federal Register Volume 67, Number 61 (Friday, March 29, 2002)]
[Rules and Regulations]
[Pages 15112-15116]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-7649]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8986]
RIN 1545-AX94


Determination of Basis of Partner's Interest; Special Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to special 
rules on determination of basis of a partner's interest under section 
705 of the Internal Revenue Code. The final regulations are necessary 
to coordinate sections 705 and 1032.

DATES: Effective Date: These regulations are effective on March 29, 
2002.
    Applicability Date: These regulations are applicable with respect 
to sales or exchanges of stock occurring after December 6, 1999.

FOR FURTHER INFORMATION CONTACT: Barbara MacMillan or Rebekah A. Myers 
(202) 622-3050 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    In Rev. Rul. 99-57 (1999-2 C.B. 678), the IRS issued guidance with 
respect to the tax consequences for a partnership and a corporate 
partner where the corporate partner contributes its own stock to the 
partnership, and the partnership later exchanges the stock with a third 
party in a taxable transaction. Under that ruling, section 1032 will 
protect a corporate partner from recognizing gain or loss (to the 
extent allocated to such partner) when the partnership exchanges stock 
of the corporate partner in a taxable transaction. The ruling also 
concludes that, under section 705, the corporate partner increases its 
basis in its partnership interest by an amount equal to its share of 
the gain resulting from the partnership's sale or exchange of the 
stock.
    In situations where a corporation acquires an interest in a 
partnership that holds that corporation's stock, a section

[[Page 15113]]

754 election is not in effect with respect to the partnership for the 
taxable year in which the corporation acquires the partnership 
interest, and the partnership later sells or exchanges the stock, it 
may be inconsistent with the intent of sections 705 and 1032 to 
increase the basis of the corporation's partnership interest by the 
full amount of the gain that is not recognized.
    For instance, assume that a corporation (A) purchases a 50 percent 
interest in a partnership for $100,000. The partnership's only asset is 
A stock with a basis of $100,000 and a value of $200,000. If the 
partnership had not made a section 754 election, then when the 
partnership disposes of the property for $200,000, A would be allocated 
$50,000 of gain. Under section 1032, the gain allocated to A would not 
be subject to tax. If A's basis in the partnership interest were 
increased to $150,000 under section 705(a)(1), A would recognize a 
corresponding $50,000 loss (or reduced gain) upon a subsequent sale of 
the partnership interest. In this situation, it would be inconsistent 
with the intent of sections 705 and 1032 to increase the basis of A's 
partnership interest for the gain that is not recognized. To do so 
would create a recognizable loss (or reduced gain) in a situation where 
no economic loss was incurred and no offsetting gain had previously 
been recognized.
    Accordingly, in Notice 99-57 (1999-2 C.B. 692), the IRS announced 
that it intended to promulgate regulations under section 705 to address 
certain situations where a corporation acquires an interest in a 
partnership that holds stock in that corporation, and a section 754 
election is not in effect with respect to the partnership for the 
taxable year in which the corporation acquired the interest. The IRS 
announced that rules regarding tiered-entity structures also would be 
included in the regulations. The IRS requested comments as to the 
appropriate scope of the regulations regarding other situations where 
the price paid for a partnership interest reflects built-in gain or 
accrued income items that will not be subject to tax, or built-in loss 
or accrued deductions that will be permanently denied, when allocated 
to the transferee partner, and the partnership has not made an election 
under section 754. No formal comments were received.
    On January 3, 2001, the Treasury Department and the IRS published a 
notice of proposed rulemaking (REG-106702-00, 2001-4 I.R.B. 424) under 
section 705 of the Internal Revenue Code (Code) in the Federal Register 
(66 FR 315). Only one commentator submitted written comments in 
response to the notice of proposed rulemaking, and no public hearing 
was requested or held. After consideration of the comment, the proposed 
regulations are adopted as revised by this Treasury decision.

Explanation of Revisions and Summary of Contents

1. Overview of Provisions

    As discussed in Notice 99-57, these final regulations are being 
issued in order to prevent inappropriate increases or decreases in the 
adjusted basis of a corporate partner's interest in a partnership 
resulting from the partnership's disposition of the corporate partner's 
stock.
    The final regulations set forth a detailed statement of the purpose 
for these regulations which is consistent with the discussion in Notice 
99-57. The final regulations then provide a specific rule implementing 
this purpose in situations where a corporate partner holds a direct 
interest in a partnership that owns stock of the corporate partner. 
This rule applies where a corporation acquires an interest in a 
partnership that holds stock in that corporation (or the partnership 
subsequently acquires stock in that corporation in an exchanged basis 
transaction), the partnership does not have an election under section 
754 in effect for the year in which the corporation acquires the 
interest, and the partnership later sells or exchanges the stock. In 
these situations, the increase (or decrease) in the corporation's 
adjusted basis in its partnership interest resulting from the sale or 
exchange of the stock equals the amount of gain (or loss) that the 
corporate partner would have recognized (absent the application of 
section 1032) if, for the taxable year in which the corporation 
acquired the interest, a section 754 election had been in effect.
    The purpose of these final regulations cannot be avoided through 
the use of tiered partnerships or other arrangements. For example, the 
final regulations provide that if a corporation acquires an indirect 
interest in its own stock through a chain of two or more partnerships 
(either where the corporation acquires a direct interest in a 
partnership or where one of the partnerships in the chain acquires an 
interest in another partnership), and gain or loss from the sale or 
exchange of the stock is subsequently allocated to the corporation, 
then the bases of the interests in the partnerships included in the 
chain shall be adjusted in a manner that is consistent with the purpose 
of the final regulations. As stated above, the final regulations 
include a statement describing the purpose of these regulations which 
is intended to guide taxpayers in making basis adjustments in the 
tiered partnership context. In addition, the final regulations include 
two examples illustrating the basis adjustments that are required by 
the final regulations where a corporation acquires an indirect interest 
in its own stock through a chain of two or more partnerships.

2. The Secretary's Authority

    The only comment received in response to the notice of proposed 
rulemaking discussed the Secretary's authority under section 705 to 
issue the regulations as proposed. Specifically, the comment suggested 
that the regulations could be challenged as inconsistent with the plain 
language of section 705. The comment acknowledged that the proposed 
regulations are a reasonable interpretation of section 705, but argued 
that the aggregate treatment of partnerships in the context of section 
1032 provides a stronger basis for the Secretary's authority.
    Accordingly, the final regulations clarify that the authority for 
the regulations includes both sections 705 and 1032. As explained in 
Rev. Rul. 99-57, the use of the aggregate theory of partnerships in the 
context of section 1032 is necessary to carry out the intent of that 
section. To reflect this application of the aggregate theory of 
partnerships and prevent any unintended benefit or detriment to the 
partners, appropriate adjustments under section 705 must be made to a 
corporate partner's outside basis. See H.R. Rep. No. 1337, 83d Cong., 
2d Sess. 225 (1954); S. Rep. No. 1337, 83d Cong. 2d Sess. 384 (1954). 
Thus, the regulations provide the mechanical rules necessary to 
implement Congressional intent under both sections 705 and 1032.

3. Technical Correction Relating to Tiered Partnerships

    The comment suggested technical changes to the proposed regulations 
to prevent taxpayers in tiered partnership situations from 
inappropriately allocating to the corporate partner a loss resulting 
from a sale of a lower-tier partnership (LTP) interest that is 
attributable to gain allocated to and recognized by the noncorporate 
partners upon the LTP's sale of the corporate partner's stock. The 
final regulations include modifications to prevent such inappropriate 
allocations.

[[Page 15114]]

4. De Minimis Rule

    The comment suggested that an elective de minimis rule would be 
appropriate as a matter of administrative convenience. However, after 
considering the purpose of these regulations and issues of 
administrative burden and technical complexity, Treasury and the IRS 
have determined that a de minimis rule is unnecessary.

5. Scope of the Regulations

    The comment suggested that the regulations provide guidance with 
respect to the issues addressed in Rev. Rul. 96-10 (1996-1 C.B. 138) 
(partners' bases in their partnership interests are increased to 
reflect gain from the sale of partnership property that is not 
recognized under sections 267(d) and 707(b)(1)) and Rev. Rul. 96-11 
(1996-1 C.B. 140) (a charitable contribution of property by a 
partnership reduces each partner's basis in the partnership by the 
partner's share of the partnership's basis in the property 
contributed). Treasury and the IRS believe that these issues are beyond 
the scope of these regulations. Accordingly, this comment is not 
addressed in these regulations.

6. Other Developments

    The notice of proposed rulemaking issued elsewhere in this issue of 
the Federal Register addresses remaining issues that Treasury and the 
IRS considered during the development of the final regulations. 
Specifically, the proposed regulations apply principles similar to 
those applied in the final regulations where a corporation's indirect 
interest in its own stock held through one or more partnerships 
increases as the result of a distribution of partnership property to 
another partner and the partnership does not have a section 754 
election in effect at the time of the distribution. In addition, the 
proposed regulations clarify that references in the regulations to 
stock of a corporate partner include any position in stock of a 
corporate partner to which section 1032 applies. Certain minor, 
nonsubstantive changes were made to the final regulations to 
accommodate the eventual incorporation of the proposed regulations.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, the 
notice of proposed rulemaking preceding these regulations was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small businesses.

Drafting Information

    The principal author of these regulations is Barbara MacMillan of 
the Office of the Associate Chief Counsel (Passthroughs and Special 
Industries). However, personnel from other offices of the IRS and the 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    1. The authority citation for part 1 is amended by adding a 
citation to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.705-2 also issued under 26 U.S.C. 705 and 1032. * * *

    2. Section 1.705-1 is amended by adding paragraph (a)(7) to read as 
follows:


Sec. 1.705-1  Determination of basis of partner's interest.

    (a) * * *
    (7) For basis adjustments necessary to coordinate sections 705 and 
1032 in certain situations in which a partnership disposes of stock of 
a corporation that holds a direct or indirect interest in the 
partnership, see Sec. 1.705-2.
* * * * *
    3. Section 1.705-2 is added to read as follows:


Sec. 1.705-2  Basis adjustments coordinating sections 705 and 1032.

    (a) Purpose. This section coordinates the application of sections 
705 and 1032 and is intended to prevent inappropriate increases or 
decreases in the adjusted basis of a corporate partner's interest in a 
partnership resulting from the partnership's disposition of the 
corporate partner's stock. The rules under section 705 generally are 
intended to preserve equality between the adjusted basis of a partner's 
interest in a partnership (outside basis) and such partner's share of 
the adjusted basis in partnership assets (inside basis). However, in 
situations where a section 754 election was not in effect for the year 
in which a partner acquired its interest, the partner's inside basis 
and outside basis may not be equal. In these situations, gain or loss 
allocated to the partner upon disposition of the partnership assets 
that is attributable to the difference between the adjusted basis of 
the partnership assets absent the section 754 election and the adjusted 
basis of the partnership assets had a section 754 election been in 
effect generally will result in an adjustment to the basis of the 
partner's interest in the partnership under section 705(a). Such gain 
(or loss) therefore generally will be offset by a corresponding 
decrease in the gain or increase in the loss (or increase in the gain 
or decrease in the loss) upon the subsequent disposition by the partner 
of its interest in the partnership. Where such a difference exists with 
respect to stock of a corporate partner that is held by the 
partnership, gain or loss from the disposition of corporate partner 
stock attributable to the difference is not recognized by the corporate 
partner under section 1032. To adjust the basis of the corporate 
partner's interest in the partnership for this unrecognized gain or 
loss would not be appropriate because it would create an opportunity 
for the recognition of taxable gain or loss on a subsequent disposition 
of the partnership interest where no economic gain or loss has been 
incurred by the corporate partner and no corresponding taxable gain or 
loss had previously been allocated to the corporate partner by the 
partnership.
    (b) Single partnership--(1) Required adjustments relating to 
acquisitions of partnership interest. (i) This paragraph (b)(1) applies 
in situations where a corporation acquires an interest in a partnership 
that holds stock in that corporation (or the partnership subsequently 
acquires stock in that corporation in an exchanged basis transaction), 
the partnership does not have an election under section 754 in effect 
for the year in which the corporation acquires the interest, and the 
partnership later sells or exchanges the stock. In these situations, 
the increase (or decrease) in the corporation's adjusted basis in its 
partnership interest resulting from the sale or exchange of the stock 
equals the amount of gain (or loss) that the corporate partner would 
have recognized (absent the application of section 1032) if, for the 
year in which

[[Page 15115]]

the corporation acquired the interest, a section 754 election had been 
in effect.
    (ii) The provisions of this paragraph (b)(1) are illustrated by the 
following example:

    Example. (i) A, B, and C form equal partnership PRS. Each 
partner contributes $30,000 in exchange for its partnership 
interest. PRS has no liabilities. PRS purchases stock in corporation 
X for $30,000, which appreciates in value to $120,000. PRS also 
purchases inventory for $60,000, which appreciates in value to 
$150,000. A sells its interest in PRS to corporation X for $90,000 
in a year for which an election under section 754 is not in effect. 
PRS later sells the X stock for $150,000. PRS realizes a gain of 
$120,000 on the sale of the X stock. X's share of the gain is 
$40,000. Under section 1032, X does not recognize its share of the 
gain.
    (ii) Normally, X would be entitled to a $40,000 increase in the 
basis of its PRS interest for its allocable share of PRS's gain from 
the sale of the X stock, but a special rule applies in this 
situation. If a section 754 election had been in effect for the year 
in which X acquired its interest in PRS, X would have been entitled 
to a basis adjustment under section 743(b) of $60,000 (the excess of 
X's basis for the transferred partnership interest over X's share of 
the adjusted basis to PRS of PRS's property). See Sec. 1.743-1(b). 
Under Sec. 1.755-1(b), the basis adjustment under section 743(b) 
would have been allocated $30,000 to the X stock (the amount of the 
gain that would have been allocated to X from the hypothetical sale 
of the stock), and $30,000 to the inventory (the amount of the gain 
that would have been allocated to X from the hypothetical sale of 
the inventory).
    (iii) If a section 754 election had been in effect for the year 
in which X acquired its interest in PRS, the amount of gain that X 
would have recognized upon PRS's disposition of X stock (absent the 
application of section 1032) would be $10,000 (X's share of PRS's 
gain from the stock sale, $40,000, minus the amount of X's basis 
adjustment under section 743(b), $30,000). See Sec. 1.743-1(j). 
Accordingly, the increase in the basis of X's interest in PRS is 
$10,000.

    (2) [Reserved]
    (c) Tiered partnerships and other arrangements--(1) Required 
adjustments. The purpose of these regulations as set forth in paragraph 
(a) of this section cannot be avoided through the use of tiered 
partnerships or other arrangements. For example, if a corporation 
acquires an indirect interest in its own stock through a chain of two 
or more partnerships (either where the corporation acquires a direct 
interest in a partnership or where one of the partnerships in the chain 
acquires an interest in another partnership), and gain or loss from the 
sale or exchange of the stock is subsequently allocated to the 
corporation, then the bases of the interests in the partnerships 
included in the chain shall be adjusted in a manner that is consistent 
with the purpose of this section.
    (2) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. Acquisition of upper-tier partnership interest by 
corporation. (i) A, B, and C form a partnership (UTP), with each 
partner contributing $25,000. UTP and D form a partnership (LTP). 
UTP contributes $75,000 in exchange for its interest in LTP, and D 
contributes $25,000 in exchange for D's interest in LTP. Neither UTP 
nor LTP has any liabilities. LTP purchases stock in corporation E 
for $100,000, which appreciates in value to $1,000,000. C sells its 
interest in UTP to corporation E for $250,000 in a year for which an 
election under section 754 is not in effect for UTP or LTP. LTP 
later sells the E stock for $2,000,000. LTP realizes a $1,900,000 
gain on the sale of the E stock. UTP's share of the gain is 
$1,425,000, and E's share of the gain is $475,000. Under section 
1032, E does not recognize its share of the gain.
    (ii) With respect to the basis of UTP's interest in LTP, if all 
of the gain from the sale of the E stock (including E's share) were 
to increase the basis of UTP's interest in LTP, UTP's basis in such 
interest would be $1,500,000 ($75,000 + $1,425,000). The fair market 
value of UTP's interest in LTP is $1,500,000. Because UTP did not 
have a section 754 election in effect for the taxable year in which 
E acquired its interest in UTP, UTP's basis in the LTP interest does 
not reflect the purchase price paid by E for its interest. 
Increasing the basis of UTP's interest in LTP by the full amount of 
the gain that would be recognized (in the absence of section 1032) 
on the sale of the E stock preserves the conformity between UTP's 
inside basis and outside basis with respect to LTP (i.e., UTP's 
share of LTP's cash is equal to $1,500,000, and UTP's basis in the 
LTP interest is $1,500,000) and appropriately would cause UTP to 
recognize no gain or loss on the sale of UTP's interest in LTP 
immediately after the sale of the E stock. Accordingly, increasing 
the basis of UTP's interest in LTP by the entire amount of gain 
allocated to UTP (including E's share) from LTP's sale of the E 
stock is consistent with the purpose of this section. The $1,425,000 
of gain allocated by LTP to UTP will increase the adjusted basis of 
UTP's interest in LTP under section 705(a)(1). The basis of UTP's 
interest in LTP immediately after the sale of the E stock is 
$1,500,000.
    (iii) With respect to the basis of E's interest in UTP, if E's 
share of the gain allocated to UTP and then to E were to increase 
the basis of E's interest in UTP, E's basis in such interest would 
be $725,000 ($250,000 + $475,000) and the fair market value of such 
interest would be $500,000, so that E would recognize a loss of 
$225,000 if E sold its interest in UTP immediately after LTP's 
disposition of the E stock. It would be inappropriate for E to 
recognize a taxable loss of $225,000 upon a disposition of its 
interest in UTP because E would not incur an economic loss in the 
transaction, and E did not recognize a taxable gain upon LTP's 
disposition of the E stock that appropriately would be offset by a 
taxable loss on the disposition of its interest in UTP. Accordingly, 
increasing E's basis in its UTP interest by the entire amount of 
gain allocated to E from the sale of the E stock is not consistent 
with the purpose of this section. (Conversely, because A and B were 
allocated taxable gain on the disposition of the E stock, it would 
be appropriate to increase A's and B's bases in their respective 
interests in UTP by the full amount of the gain allocated to them.)
    (iv) The appropriate basis adjustment for E's interest in UTP 
upon the disposition of the E stock by LTP can be determined as the 
amount of gain that E would have recognized (in the absence of 
section 1032) upon the sale by LTP of the E stock if both UTP and 
LTP had made section 754 elections for the taxable year in which E 
acquired the interest in UTP. If section 754 elections had been in 
effect for UTP and LTP for the year in which E acquired E's interest 
in UTP, the following would occur. E would be entitled to a $225,000 
positive basis adjustment under section 743(b) with respect to the 
property of UTP. The entire basis adjustment would be allocated to 
UTP's only asset, its interest in LTP. In addition, the sale of C's 
interest in UTP would be treated as a deemed sale of E's share of 
UTP's interest in LTP for purposes of sections 754 and 743. The 
deemed selling price of E's share of UTP's interest in LTP would be 
$250,000 (E's share of UTP's adjusted basis in LTP, $25,000, plus 
E's basis adjustment under section 743(b) with respect to the assets 
of UTP, $225,000). The deemed sale of E's share of UTP's interest in 
LTP would trigger a basis adjustment under section 743(b) of 
$225,000 with respect to the assets of LTP (the excess of E's share 
of UTP's adjusted basis in LTP, including E's basis adjustment 
($225,000), $250,000, over E's share of the adjusted basis of LTP's 
property, $25,000). This $225,000 adjustment by LTP would be 
allocated to LTP's only asset, the E stock, and would be segregated 
and allocated solely to E. The amount of LTP's gain from the sale of 
the E stock (before considering section 743(b)) would be $1,900,000. 
E's share of this gain, $475,000, would be offset in part by the 
$225,000 basis adjustment under section 743(b), so that E would 
recognize gain equal to $250,000 in the absence of section 1032.
    (v) If the basis of E's interest in UTP were increased by 
$250,000, the total basis of E's interest would equal $500,000. This 
would conform to E's share of UTP's basis in the LTP interest 
($1,500,000  x  1/3 = $500,000) as well as E's indirect share of the 
cash held by LTP ((1/3  x  3/4)  x  $2,000,000 = $500,000). Such a 
basis adjustment does not create the opportunity for the recognition 
of an inappropriate loss by E on a subsequent disposition of E's 
interest in UTP and is consistent with the purpose of this section. 
Accordingly, under this paragraph (c), of the $475,000 gain 
allocated to E, only $250,000 will apply to increase the adjusted 
basis of E in UTP under section 705(a)(1). E's adjusted basis in its 
UTP interest following the sale of the E stock is $500,000.
    Example 2. Acquisition of lower-tier partnership interest by 
upper-tier partnership. (i) A, corporation B, and C form

[[Page 15116]]

an equal partnership (UTP), with each partner contributing $100,000. 
D, E, and F also form an equal partnership (LTP), with each partner 
contributing $30,000. LTP purchases stock in corporation B for 
$90,000, which appreciates in value to $900,000. LTP has no 
liabilities. UTP purchases D's interest in LTP for $300,000. LTP 
does not have an election under section 754 in effect for the 
taxable year of UTP's purchase. LTP later sells the B stock for 
$900,000. UTP's share of the gain is $270,000, and B's share of that 
gain is $90,000. Under section 1032, B does not recognize its share 
of the gain.
    (ii) With respect to the basis of UTP's interest in LTP, if all 
of the gain from the sale of the B stock (including B's share) were 
to increase the basis of UTP's interest in LTP, UTP's basis in the 
LTP interest would be $570,000 ($300,000 + $270,000), and the fair 
market value of such interest would be $300,000, so that B would be 
allocated a loss of $90,000 (($570,000--$300,000)  x  1/3) if UTP 
sold its interest in LTP immediately after LTP's disposition of the 
B stock. It would be inappropriate for B to recognize a taxable loss 
of $90,000 upon a disposition of UTP's interest in LTP. B would not 
incur an economic loss in the transaction, and B was not allocated a 
taxable gain upon LTP's disposition of the B stock that 
appropriately would be offset by a taxable loss on the disposition 
of UTP's interest in LTP. Accordingly, increasing UTP's basis in its 
LTP interest by the gain allocated to B from the sale of the B stock 
is not consistent with the purpose of this section. (Conversely, 
because E and F were allocated taxable gain on the disposition of 
the B stock, it would be appropriate to increase E's and F's bases 
in their respective interests in LTP by the full amount of such 
gain.)
    (iii) The appropriate basis adjustment for UTP's interest in LTP 
upon the disposition of the B stock by LTP can be determined as the 
amount of gain that UTP would have recognized (in the absence of 
section 1032) upon the sale by LTP of the B stock if the portion of 
the gain allocated to UTP that subsequently is allocated to B were 
determined as if LTP had made an election under section 754 for the 
taxable year in which UTP acquired its interest in LTP. If a section 
754 election had been in effect for LTP for the year in which UTP 
acquired its interest in LTP, then with respect to B, the following 
would occur. UTP would be entitled to a $90,000 positive basis 
adjustment under section 743(b), allocable to B, in the property of 
LTP. The entire basis adjustment would be allocated to LTP's only 
asset, its B stock. The amount of LTP's gain from the sale of the B 
stock (before considering section 743(b)) would be $810,000. UTP's 
share of this gain, $270,000, would be offset, in part, by the basis 
adjustment under section 743(b), so that UTP would recognize gain 
equal to $180,000.
    (iv) If the basis of UTP's interest in LTP were increased by 
$180,000, the total basis of UTP's partnership interest would equal 
$480,000. This would conform to the sum of UTP's share of the cash 
held by LTP ((1/3  x  $900,000 = $300,000) and the taxable gain 
recognized by A and C on the disposition of the B stock that 
appropriately may be offset on the disposition of their interests in 
UTP ($90,000 + $90,000 = $180,000). Such a basis adjustment does not 
inappropriately create the opportunity for the allocation of a loss 
to B on a subsequent disposition of UTP's interest in LTP and is 
consistent with the purpose of this section. Accordingly, of the 
$270,000 gain allocated to UTP, only $180,000 will apply to increase 
the adjusted basis of UTP in LTP under section 705(a)(1). Such 
$180,000 basis increase must be segregated and allocated $90,000 
each to solely A and C. UTP's adjusted basis in its LTP interest 
following the sale of the B stock is $480,000.
    (v) With respect to B's interest in UTP, if B's share of the 
gain allocated to UTP and then to B were to increase the basis of 
B's interest in UTP, B would have a UTP partnership interest with an 
adjusted basis of $190,000 ($100,000 + $90,000) and a value of 
$100,000, so that B would recognize a loss of $90,000 if B sold its 
interest in UTP immediately after LTP's disposition of the B stock. 
It would be inappropriate for B to recognize a taxable loss of 
$90,000 upon a disposition of its interest in UTP because B would 
not incur an economic loss in the transaction, and B did not 
recognize a taxable gain upon LTP's disposition of the B stock that 
appropriately would be offset by a taxable loss on the disposition 
of its interest in UTP. Accordingly, increasing B's basis in its UTP 
interest by the gain allocated to B from the sale of the B stock is 
not consistent with the purpose of this section. (Conversely, 
because A and C were allocated taxable gain on the disposition of 
the B stock that is a result of LTP not having a section 754 
election in effect, it would be appropriate for A and C to recognize 
an offsetting taxable loss on the disposition of A's and C's 
interests in UTP. Accordingly, it would be appropriate to increase 
A's and C's bases in their respective interests in UTP by the amount 
of gain recognized by A and C.)
    (vi) The appropriate basis adjustment for B's interest in UTP 
upon the disposition of the B stock by LTP can be determined as the 
amount of gain that B would have recognized (in the absence of 
section 1032) upon the sale by LTP of the B stock if the portion of 
the gain allocated to UTP that is subsequently allocated to B were 
determined as if LTP had made an election under section 754 for the 
taxable year in which UTP acquired its interest in LTP. If a section 
754 election had been in effect for LTP for the year in which UTP 
acquired its interest in LTP, then with respect to B, the following 
would occur. UTP would be entitled to a basis adjustment under 
section 743(b) in the property of LTP of $90,000 with respect to B. 
The entire basis adjustment would be allocated to LTP's only asset, 
its B stock. The amount of LTP's gain from the sale of the B stock 
(before considering section 743(b)) would be $810,000. UTP's share 
of this gain, $270,000, would be offset, in part, by the $90,000 
basis adjustment under section 743(b), so that UTP would recognize 
gain equal to $180,000. The $90,000 basis adjustment would 
completely offset the gain that otherwise would be allocated to B.
    (vii) If no gain were allocated to B so that the basis of B's 
interest in UTP was not increased, the total basis of B's interest 
would equal $100,000. This would conform to B's share of UTP's basis 
in the LTP interest (($480,000--$180,000 (i.e., A's and C's share of 
the basis that should offset taxable gain recognized as a result of 
LTP's failure to have a section 754 election))  x  1/3 = $100,000) 
as well as B's indirect share of the cash held by LTP ((1/3  x  1/3) 
 x  $900,000 = $100,000). Such a basis adjustment does not create 
the opportunity for the recognition of an inappropriate loss by B on 
a subsequent disposition of B's interest in UTP and is consistent 
with the purpose of this section. Accordingly, under this paragraph 
(c), of the $90,000 gain allocated to B, none will apply to increase 
the adjusted basis of B in UTP under section 705(a)(1). B's adjusted 
basis in its UTP interest following the sale of the B stock is 
$100,000.
    (viii) Immediately after LTP's disposition of the B stock, UTP 
sells its interest in LTP for $300,000. UTP's adjusted basis in its 
LTP interest is $480,000, $180,000 of which must be allocated 
$90,000 each to A and C. Accordingly, upon UTP's sale of its 
interest in LTP, UTP realizes $180,000 of loss, and A and C in turn 
each realize $90,000 of loss.

    (d) [Reserved]
    (e) Effective date. This section applies to gain or loss allocated 
with respect to sales or exchanges of stock occurring after December 6, 
1999.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: March 14, 2002.
Mark Weinberger,
Assistant Secretary of the Treasury.
[FR Doc. 02-7649 Filed 3-28-02; 8:45 am]
BILLING CODE 4830-01-P